Investors can’t seem to get enough of financial technology, and venture capital continues to flow into the burgeoning array of neobanks. Should incumbent banks be scared? Perhaps they can learn from Spanish philosopher Baltasar Gracian: “A wise man gets more use from his enemies than a fool from his friends.” This blog considers the likely future of neobanks and why incumbents should “befriend” these nimble newcomers.
Neobanks are digital-only banks that operate without a physical branch network. They are primarily fintechs that offer apps and associated technologies that streamline and simplify online banking. Many neobanks offer limited financial products, principally checking and savings accounts. But the philosophy of neobanks is greater than technology – they promise simpler, more transparent banking than conventional banks, and often cater to a specific niche, demographic or interest group.
In the UK, neobanks are often known as “challenger” banks, although the two are not entirely synonymous. While all neobanks are challengers, the latter may include new banks with physical branches (such as Metrobank). The important point is that all these newcomers set out to challenge conventional banks with new technologies and business models.
The rise of challenger banks is a global phenomenon that’s been actively encouraged by governments, regulators and customers. The COVID-19 pandemic fueled a demand for digital banking to an extent that no government or financial authority could have done. Despite the impact on funding, the largest digital banks have soared in value. There are presently 83 private neobank “unicorns,” each with a pre-money valuation of over USD $1 billion.
That said, many popular neobanks have yet to make a profit. UK-based Revolut's 2020 revenue surged 34% to USD $310.5 million while its losses climbed 57% to $217 million. Profit may not be the name of the game, but it certainly tells you the score. Clearly, neobanks need to find ways to turn their popularity into profit. 
Fending off the unicorns
Although all neobanks set out to challenge conventional banks, there is no single formula for success. In addition to checking and deposit accounts, services span lending, debit cards, credit cards, investments and foreign currency.
Neobanks typically adopt different business models than conventional banks. Many rely on revenue from interchange fees, which are paid by merchants when customers pay by card. As smaller organizations, neobanks are often allowed to charge interchange percentages that are up to seven times higher than those available to banks with more than USD $10 billion in assets.
In recent years, neobanks overall have enjoyed strong growth, and venture capitalists have poured funds into these promising newcomers. But during the pandemic, we’ve seen neobank expansion plans thwarted, and their growth has flattened. Why?
With the surge in demand for remote and digital banking, many conventional banks have accelerated digitalization programs and are working hard to attract and retain customers. Although neobanks simplify everyday banking tasks like making and receiving payments, their service portfolios are often limited. And, with an absence of branches, customers may have no access to human assistance. While neobanks offer many benefits, they are not for everyone. Many bank customers chose to remain with – or move to – established brands.
Neobanks and the search for value
Some neobanks have struggled in recent years as result of prioritizing customer growth over value.
Research conducted by Cornerstone Advisors suggests that only 11% of US adults held their primary checking account at a digital bank as of December 2020. To build long-term customer loyalty and value, neobanks will need to earn customer trust. In the digital age, customers are more demanding and less loyal and will maintain multiple bank accounts with different banks to achieve the portfolio of banking services that they need or want.
Many neobanks run the risk of being unable to derive long-term value from their customers, yet they also run the risk of eroding their competitive advantage if they become too much like a conventional bank. Meantime, investors will push the neobanks to show how they plan to monetize their products.
It’s hard to predict how this story will play out because every neobank has its own value proposition and formula for success. While more M&A seems inevitable, this is also a prime opportunity to collaborate.
Open banking, collaboration and partnership
The rise of open banking is a unique opportunity for every conventional bank – and neobank – to examine its value proposition and decide which role(s) it wishes to play in the growing real-time financial ecosystem. They must look inward and outward to determine their own strengths and weaknesses and boldly explore new avenues and innovations to create more customer value collaboratively.
Many neobanks and fintechs envy the customer trust that’s inherent in an established bank’s brand. Trust is at the very heart of every banking relationship, and that trust must be earned – and sustained – over time. In addition, incumbent banks have a wealth of expertise and practical knowledge that cannot be acquired quickly. When backed by the credibility of a major bank brand, a collaborating neobank can offer a more compelling value proposition and market their fintech services more quickly and confidently.
Banks, meanwhile, must accelerate digitalization and offer a fintech approach to meet rising expectations. With the growth of new platform-based business models such as Banking-as-a-Service (BaaS), banks and neobanks can collaborate more easily than ever before and with minimal commitment. All parties have the right incentives to succeed, and the ultimate winner will be the customers who benefit from greater choice.
A natural pairing
So, are neobanks a threat or an opportunity to conventional banks?
The view here is that neobanks should be welcomed by conventional banks. They showcase how modern technology can deliver innovation, which is a wakeup call to tech laggards. Banking has become a technology business, but technology alone cannot deliver banks success. There is unlimited potential for banks and neobanks to collaborate for mutual success, and as open banking hits its stride, the time is right to start working together.